Tuesday, 12 November 2013

Are bankers wasting a good crisis

This post is concerned whether banking culture will change as a consequence of recent financial crises/scandals and offers some material that could help change banker's culture.

There is a group of political scientists and mathematicians at UCL who argue that you should never waste a good crisis, crises which can be used to force structures to re-configure themselves and evolve. I think they are right, and I often wonder if the fact that Riemann was in Berlin during the 1848 (failed) revolution had an impact on his way of seeing things that enabled him to, so successfully, re-configure geometry in 1853.

I have been thinking about the opportunities that crises present since I received a marketing e-mail from Deloitte at the weekend

Half a decade after the onset of the financial crisis, governments, regulators and senior bankers are pausing to reflect on the causes and how to avoid a repetition. Last year, The Deloitte Bank Survey tackled the subject of deleveraging. ...

The focus of debate has shifted from leverage to standards, values and culture. Many - both inside and outside the industry - now accept that many aspects of the industry’s culture were problematic and senior figures within the industry have acknowledged the need for change.

Deloitte UK has interviewed 41 senior bankers at financial institutions around the world to understand their views on the following questions:

What were the causes of these cultural problems that manifested themselves during and after the financial crisis

To what extent do cultural problems still exist?

And what can banks do about them?

You can (try to) read the report here. What grabbed my attention is the emphasis Deloitte places on "culture", and so I read on.

The first finding is that 65% of the sample believe there is a problem, but only half of these see an issue at their own institution. Three quarters think that compensation was a significant factor in creating the problems, but only a quarter felt their own institution was at fault.

At first sight these results seem wrong, there is agreement on the issue but most people are not taking responsibility. With a bit of thought though, the results are coherent, if a third of the respondents worked at problem banks it is not unreasonable that two thirds of respondents recognise the fact. However given the breadth of problems in UK banking - from leverage based speculation, through LIBOR/FX fixing, money laundering at overseas branches, to retail mis-selling - I think the lay observer of UK banking has a right to raise their eyebrows at the results.

When asked to identify "What went wrong" bankers identified the main causes as poor leadership and incentives, both issues that are within banks' abilities to control and Deloitte sees these issues as being cultural. Externally, bankers identified issues with light touch regulation but accepted that it was difficult for the regulator to retain the right skills to challenge the banks.

I don't disagree with these observations but I do think they highlight a significant issue. The system appears to be based on carrots and sticks: rational utility maximisers will attempt to break the system and so have to be constrained by rules and sanctions. I believe this carrot-stick dynamic is fundamentally unstable, not least because the people chasing the carrots are often faster than those wielding the sticks (the issue of the regulators competencies in complex, dynamic markets).

Deloitte identify the primary solution to the problems that bankers have identified as better performance management, i.e. optimally choosing the right size of carrot to dangle in front of the utility maximising miscreants to ensure that they don't escape the stick. In conjunction miscreants should be punished, i.e. the stick should hurt them. Somewhat schizophrenically, bankers think stronger regulation will be more of a hindrance than a help and that change should come from the top. This appears schizophrenic because bankers have identified problems with light touch regulation and expect sanctions to hurt, but they don't think the regulators powers should be extended. The resolution might be in keeping the regulations narrow but deep: focusing on specific issues with severe punishments, rather than broad and shallow: principles that cannot be enforced. Similarly, suggesting change should come from the top has different implications if the respondents see themselves as being part of the 'top', or if they think of themselves as following someone else's lead, in which case they are abrogating responsibility.

Reading the main body of the report what struck me was how little it actually had to say about culture. It is there but the emphasis is on processes: metrics to drive remuneration and behaviours; remuneration structures (cash or equity, immediate or deferred); communication, the ability for whistle-blowers to alert management and the need for management to "walk -the-talk". I think the final comment was the most relevant

Leadership training for senior managers was ranked the most important tool to help banks embark on cultural change process, being chosen by 58% of respondents.

I have been thinking a lot about this since meeting with the Charted Institute of Banking: Professional Standards Board in the summer: how do you teach ethics? The word "ethics" comes from the Greek for "habituation", and then became to mean the science of morals (reference), that is, ethics develop in practice and so are a difficult skill to teach in the classroom. Ethics emerges out of culture "The distinctive ideas, customs, social behaviour, products, or way of life of a particular nation, society, people, or period" (OED 7a) or "The philosophy, practices, and attitudes of an institution, business, or other organization. " (OED 7c) and so to teach ethics you must immerse the student in the right culture. But this means a culture needs to be created.

As an educator I am troubled with the question of "teaching culture". This is because I know I can train students in the rules of calculus or probability, but my task is much harder; to have the student "internalise" the nature of calculus and probability. This is difficult even with something as mechanical as calculus, but I would be really interested to understand how people would go about "training" for culture and ethics. My sense from what Deloitte say is that they believe/hope that by creating the right structures - remuneration and communication - the right culture will grow naturally on the structures. I am not so convinced of this.

My own view is not that revolutionary: it is the role of the liberal arts. The dominant theme (in film for example) associated with modern commerce is rapracious greed - Glengarry Glen Ross, Wall Street, Boiler Room, Enron, Margin Call. Whether we like it or not, Gordon Gekko, like Darth Vader (my son is going through a Star Wars phase), can be an enchanting character but unlike Vader, has a real prototype in Ivan Boesky. While Michael Lewis and Satyajit Das are explicitly critical of the excesses of trading floors, they never the less paint an attractive picture to people who have gone through school and university believing in the moral imperative of winning, whether by coming top of the class, leading the group, sporting success or being taught that the aim of finance is profit maximisation.

More subtle, and more controversial, is the culture of scientism that that I believe has become widespread as the industry has employed more and more science, engineering and mathematics graduates. These graduates, certainly if they have an narrow English education (like myself), are emerging out of a culture that struggles to appreciate the role of culture in the science they do. It depresses me how few of my undergraduate and post-graduate students trouble themselves with the nature of commerce and the 'soul' of money. All to prevalent is the view that commerce is a machine, its agents are like 'atoms', homogeneous and unconscious, and the role of the machine is to optimise the distribution of scarce resources - implicitly assuming there is no radical uncertainty. Removing these strong assumptions will divorce the practice of commerce from the culture of positivism that science graduates emerge out of.

I think if banks really want to change their cultures they need to fight fire with fire, they need to encourage their employees to absorb books and films that present an alternative view of commerce to the dominant themes they are more likely to come across. To this end I am building a library of works I think would help science trained financiers develop a stronger culture, and would be interested to know of any others.

The Name of the Rose - this was written by Italy's most famous Pragmatic philosopher, Umberto Eco. As a Pragmatist, Eco endorses scientific thinking while challenging the assumptions of scientism and one of the key messages (for me) is that it is the process, not the results, of enquiry that is important.

Decalogue 1 - this is a TV film made by Poland's most famous director Krzysztof Kieślowski, who is noted for making moral parables. The story is a tragic one of a father and son who place to much faith on computer modelling.

Parade's End - this is a quartet of books written by Ford Maddox Ford in the 1920s, though I think only the first two books are relevant and formed the basis of the BBC/HBO dramatisation. I think the hero of the books, Christopher Tietjens, personifies the virtues of statisticians, emphasising his faithfulness to what he believes is true over what is expedient (in contrast to the adultery of his wife and the ambition of MacMaster).

The Merchant of Venice - one of Shakespeare's most famous plays and notoroiously enigmatic. When I did the play for my 'O-levels' (exams taken at 16) the focus was on the anti-Semitism and the possibilities of a homosexual relationship between Antonio and Bassanio. Alternative readings on the play focus on the themes of Justice and Love. ‘Antonio, a merchant of Venice’ characterises Charity, or agape, though his sacrifices for his young friend Bassanio. The view that Antonio and Bassanio were physical lovers is a modern interpretation that does not distinguish storge (familial love, personified by Portia's obidence to her dead father, the deficit between Jessica and her father Shylock), philia (friendship, Portia/Nerissa, Lorenzo/Bassanio, etc), eros (physical love, Portia/Bassanio, Lorenzo/Jessica) and agape (spiritual love, Antonio/Bassanio, Shylock’s deficit), clear themes running through the play. Justice is a constant theme focussed on Portia and the play culminates in a famous court scence that rests on the idea that Shylock will take more than what was contracted to. Chance also plays a pivotal role in the casket game.

The Baroque Cycle - this is a contemporary trilogy written by the 'science fiction' writer Neal Stephenson. I stumbled across the books but think they are great for intervening topics in science and finance in an entertaining way. They are less obviously morality tales than the other works but they place an important emphasis on the nature of money and the relationships between scientific and commercial cultures (in the Enlightenment). They open up the possibilities of exploring the doux-commerce thesis.

There are various dimensions for thinking about Athena: her role in the Pandora Myth; as mother to Erichthonius who was regarded as the inventor of money and father of Tyche (Fortuna) - both stories involve Hephaestus, the god of technology.

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About Me

I am a Lecturer in Financial Mathematics at Heriot-Watt University in Edinburgh. Heriot-Watt was the first UK university to offer degrees in Actuarial Science and Financial Mathematics and is a leading UK research centre in the fields.

Between 2006-2011 I was the UK Research Council's Academic Fellow in Financial Mathematics and was involved in informing policy makers of mathematical aspects of the Credit Crisis.